Instructure: Premium Growth In Sticky Ed-Tech Market – Instructure (NYSE:INST)

If you attended college any time in the past 5 years, you’ve probably used Canvas by Instructure (NASDAQ: INST) in your classes. This Utah-based software company is the developer of one of the most widely used online course management systems in the U.S., and it’s catching on quickly with education administrators and growing like a weed.

Gone is the age of paper and pen. Professors aren’t grading papers and exams by hand anymore – they’re reviewing submissions online, marking up comments and submitting grades with the help of a learning management system (LMS). Not only does LMS software save administrative time for educators, it also gives students 24/7 access to course materials, as well as an intuitive platform for disseminating assignments and hosting discussion boards.

As the millennial generation is growing accustomed to consuming all of their content online, education systems are pivoting to this delivery model as well. And once a university or school signs on with Canvas, they are notoriously sticky customers (imagine how much time and how many levels of approval it would take to uproot a campus-wide system) – providing a steady stream of recurring monthly billings at high ~70% gross margins.

Instructure has also diversified away from solely serving the education vertical – its corporate learning platform, Bridge, addresses employee training and career development tools similar to the likes of Cornerstone OnDemand (NASDAQ: CSOD). With a foothold in two extremely large target markets – education at all levels, and corporations of all sizes – Instructure is well poised for multiple years of high double-digit growth, while marching to profitability as well.

The stock can be had for a relative bargain as well – trading at just 5x forward revenues, Instructure trades at a turn or two lower than other “sexier” software names that are growing at the same pace.

INST data by YCharts

Though the stock has risen ~50% year to date already, Instructure’s low valuation as well as rapid growth positions it well for a continued climb. As the S&P 500 and NASDAQ march to record highs, positioning a tech portfolio toward quality value names becomes of utmost importance. This article will give a rundown on Instructure’s products, review its numbers and compare its valuation in context against the broader software sector. Overall, Instructure will make a solid addition to a portfolio seeking premium growth at reasonable values.

Product overview

Canvas, Instructure’s main product, is a learning management system intended for use by universities and K-12 schools. By using Canvas, an educational institution can largely move much of its processes online. Quizzes and assignments can be delivered via Canvas, grading can be done within the application and posted for students to view.

Canvas was launched in 2011 and has since grown to 2,000+ customers, including seven of the Ivy League schools. Canvas is delivered via the SaaS cloud model (it’s hosted in Amazon AWS), minimizing the upfront investment for potential customers who are billed on a monthly basis.

The below screenshot from Instructure’s website shows a demo of the user interface within a sample Biology class:

Figure 1. Canvas demoIn 2015, coinciding with Instructure’s $40-million Series E round, Canvas also took the core code of Canvas and reconfigured it to create Bridge, the learning management system tailored to corporate customers.

Bridge’s core features allow companies to create and assign training modules to employees, deliver and track compliance/regulatory training, track employee learning progress, and also provide training to reseller channels and other third-party partners.

Bridge opens up another large market for Instructure with potential revenues in the hundreds of millions – its best-known competitor in the space is fellow SaaS peer Cornerstone OnDemand, which has $400 million in annual revenue. Cornerstone has recently also engaged Goldman Sachs (NYSE: GS) to explore a potential sale of the company, indicating that corporate learning software is potentially a desirable asset for a larger company to acquire in its applications portfolio.

Financial overview

Instructure has grown rapidly since introducing Canvas in 2011. In its first full year of operations, 2012, the company posted only $8.8 million in revenue; in 2016, it posted $111 million.

Figure 2. Instructure financials, 2012-2016In 2016, Instructure’s revenues grew an impressive 51.5%, while delivering operating leverage improvements as well. Capturing efficiencies on cloud delivery due to its increased scale, Instructure’s gross margins have consistently improved since launching:

Figure 3. Instructure gross marginLike any good software company, Instructure’s colossal gross margins indicate that almost every new deal is pure profit – after all, it costs virtually nothing to provide the Canvas application to the incremental customer, only the hosting fees in AWS. Building atop high gross margins indicates a company that has enormous profit potential, especially as it begins to scale down its other costs.

Figure 4. Instructure operating marginThe above chart also shows the vast improvements Instructure has made in its operating margin as well. Most notably, the company has been able to cut down on its sales and marketing spend on the order of ~10% per year, as the company’s sales force becomes more tenured and moves toward optimal productivity.

Instructure’s pattern of continued growth along with operating improvements has rolled into its current year resales as well. In its second quarter, announced in late July, Instructure posted $38.0 million in revenue, representing a 47% y/y increase to the top line. Operating losses came in at just -34%, a far cry from the prior-year quarter at -56%. The improvement in efficiency was driven, again, largely by a reduction in sales and marketing spend as a percentage of revenues, indicating the company’s continued path to maturity.

In true beat-and-raise style, Instructure also raised its full-year guidance in tandem with its Q2 beat. It’s guiding to revenues of $152.9 to $154.1 million for FY17, implying 39% growth at the midpoint of the range (previously, guidance had been $150.7 to $152.2 million).

There’s a lot of room for outperformance on this guidance range. Given that the company’s 1H17 revenues of $72 million grew 46% relative to the first half of the prior year, Instructure would really have to slow down growth in the back half of the year to hit only 39% growth. Calculating what this slowdown would have to be:

Instructure posted $61.7 million in the second half of 2016. To hit the company’s guidance midpoint of $153.6 million, Instructure would have to post only $81.6 million in second-half revenues – only a 32% increase from 2H16.

This seems unlikely for a company that grew a stunning 46% in its first half, especially given that educational activity picks up in the back half of the year when summer is over and administrators are in full swing. I would expect Instructure to post at least 40% growth in its second half, implying $158-160 million in full-year revenues (or at least a ~4% beat to current guidance).

The company’s lowballed guidance should give the stock ample room to run after Q3 and Q4 results.

Final thoughts and valuation

Finally, we turn to the crux of this thesis: Instructure delivers premium growth and a sticky product, at a discounted value.

Let’s compare Instructure’s valuation to other software companies growing in the ~40% bucket:

Figure 5. Instructure trading comps

Note: Market cap based on close of trading on September 15; balance sheet and cash flow figures taken from most recent quarter; forward revenues based on extrapolation of management guidance

Versus other companies growing at roughly the same pace, Instructure trades at a 1-1.5x discount, which is puzzling. Like many of the other companies in this comp set, Instructure delivers a high-margin, subscription-based product with sticky revenues. Perhaps investors see the education vertical as less capable of explosive growth than the typical enterprise software market; but Instructure’s introduction of Bridge has also given it a foothold in the core corporate customer world as well.

Furthermore, Instructure has delivered operating margin growth on the order of ~10% per year, which is faster than most software companies are capable of scaling.

I believe Instructure to be temporarily undervalued – a few more quarters of outperforming earnings should close the valuation gap. A revenue multiple of 6x would be an appropriate near-term valuation for Instructure, implying a price target of $38. In addition, any further buzz from the pending Cornerstone OnDemand sale overtures may give lift to Instructure’s stock.

Investors would be wise to get in on the ground now while Instructure is still a value play.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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